Chapter 4: Operational, Financial, and Strategic Risk - Review (Part 2 - Financial) Flashcards
(17 cards)
Three major types of financial risk
Market risk
Credit risk
Price risk
Two characteristics of financial risk
- External risk with potential to affect an organization’s objectives
- Risk can be reduced through a financial contract (ex. a derivative)
Goal of fiancial risk management and methods to achieve it
- Goal is risk optimization (protect against downside risk while capturing upside risk)
- Hedging is a common approach (ex. an airline purchasing futures contracts in fuel to offset volatility in prices)
- Can purchase both call and put options (i..e a collar) to provie a price range - can buy and sell commodity at specifried prices which limit price risk in either direction
What is market risk?
Market risk arises from change sin the value of financial instruments. Can be systematic (i.e. common to all securities) or nonsystematic.
Five major categories of market risk
- Currency price risk
- Interest rate risk
- Commodity price risk
- Equity price risk
- Liquidity risk
Currency price risk
(Category of market risk)
- Organizations that operate in more than one country have risks related to change sin the currency exchange rates between countries
- Ex. a company that manufactures products in one country and sells in another
Interest rate risk
(Category of market risk)
- Systematic risk that affects all organizations (ex. rates on bonds, bank interest etc.)
- Severla risk management techniques - variable interest rates can be negoitated, or swaps can be used
Two reasons why insurers are vulnerable to interest rate risk
- Insurers have investments (ex. bonds) with durations linked to expected claims payments
- Insurers earn much of their income from investment returns on reserves before they are needed to pay claims
Advantages and disadvantages of cash matching as a means of eliminating interest rate risk
- Cash matching: matching an investment’s maturity value witht he amount of expected loss payments
- Provides a predictable stream of income until losses are due - insurer just needs to hold investment until it matures
- Limitations: only works if insurer can purchase zero-coupon bonds with maturity dates that match outflows from underwriting portfolio
- Even if zero-coupon bondsa re available, insurer would need to purchase enough to match expected claim payments
Commodity price risk
(Category of market risk)
- Affects many types of organizations (ex. fuel prices, cots of agricultural products etc. which can affect cash flow)
- Organizations can manage commodity price risk through purchase of commodity futures contracts
Equity price risk
(Category of market risk)
- Risk related to organization’s own share price
- Risks related to investments in external stocks and other securities
- Risks related to average share price in a market
Risk management techniques for equity price risks
- Heding with derivatives and options
- Call options and put options allow an investor to narrow the range of price risk for a security
Liquidty risk
(Category of market risk)
- Related to an organization’s cash or its ability to raise cash
- Closely related to an organization’s solvency (abilityt o meet financial obligations)
Two distinct types of liquidy risk and how to manage them
- Possibility that large numbers of clients could withdraw funds (a run on the bank)
- The possibility of off-blance sheet commitments, such as a line of credit, being exercised
Organizations can use stored liquidity (cash reserve) or purchased liquidity (cash raised in credit markets) to manage risk)
Credit risk
(Category of market risk)
- Unlike market risk, credit risk has only negative potential (ex. if a borrower repays, no risk. If they default, risk of loss)
- All organizations have some exposure to credit risk
Two types of credit risk
Firm-specific risk
* Specific to a particular financial institution, associated with credit transactions
* Ex. home mortgages, credit cards, loans, lines of credit
* Risk management includes diversification, evaluating creditworthiness, transferring risk bys elling loans
Systemic credit risk
* Selling loans to other organizations
* If loans are provided and then re-sold to other institutions, a large number of defaults can create a systemic credit crisis (ex. 2008 subprime mortgage loans)
Price risk
(Category of market risk)
- Price risk has both positive and negative potential
- Two aspects for most organizations: 1) price charged for organizations’ products or services, 2) price of assets purchased or sold by an organization
